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3 Reasons Why Penny Stocks Are Such a Dangerous Investment

Three penny stock risks to watch out for.

Penny stocks are the realm of dreams and nightmares for speculators. Common wisdom holds that in order to be a successful investor, you often have to be contrarian and invest in assets everyone else avoids. However, there are good reasons to avoid penny stocks.

We asked our Motley Fool experts to name some reasons to avoid penny stocks. Here's what they had to say.

Dan DzombakOne reason penny stocks are such a dangerous investment is that their markets have much less stringent requirements regarding financial transparency, governance, and assets than the New York Stock Exchange or Nasdaq.

Penny stocks are frequently traded on the pink sheets or on the over-the-counter market. The level of transparency and disclosure varies from market to market, but it can range from current and full reports on financials to none at all. Furthermore, there are no requirements for the companies themselves regarding corporate governance or quality. You'll find companies with no assets, income, or revenue that trade just like established companies. If you aren't careful, it's possible to get suckered into buying something worthless.

In contrast, to list on the major markets, companies must have assets and revenue, and they must meet standards of corporate governance. For example, companies on the NYSE must keep a minimum share price of $2, have positive shareholder equity of $4 million, or have at least $75 million in both total assets and revenue or a $75 million market capitalization.

As they say in poker, "If after 10 minutes at the poker table you do not know who the patsy is, you are the patsy." Make sure you aren't the patsy in the penny stock market.

Dan CaplingerOne big problem in dealing with penny stocks is that the market for buying and selling shares tends to be quite illiquid, often with a potentially disreputable market-maker being the only party willing to take the other side of your trade in either direction. That's especially dangerous given the investors' tendency to find out about penny stocks through direct promotions that spur a herd of activity from multiple buyers or sellers.

The danger of an illiquid market is that you can be taken advantage of twice. If you seek to buy shares, even small dollar amounts can actually move the market, forcing you to pay a higher price than you otherwise would in order to complete your order. Later on, when you sell out of your position, you can experience the opposite effect: Your attempt to dispose of your shares creates enough selling pressure to depress the stock price. The net effect is to reduce any profit you're lucky enough to earn -- or, more likely, to make your losses larger than they otherwise would be. The best solution is to avoid illiquid stocks of all kinds, or at the very least to exercise caution by using limit orders rather than market orders to ensure you don't pay more than you want to for shares.

Jordan WathenPenny stock companies are usually small, and small companies generally attract fewer prying eyes. That opens the door to mismanagement by executives, who often see a business's assets and earnings power as the property of insiders, not outside stockholders.

Conflicts of interest abound. I've seen penny stock companies lease office space from their executives at above-market prices. Others hire or purchase private aircraft, which are then used more frequently for executive leisure than for business. And some of the worst offenders will downright reject proposals by shareholders, knowing those people are individual investors who don't have the resources to seek legal recourse.

That isn't to say that these conflicts only arise in the world of penny stocks. It's just that they are far more common there, and the impact is far more devastating to small companies than to large ones. Buyer beware.

Author

Dan Dzombak has written for The Motley Fool since 2008. He covers value investing, investing process, and success among other things. You can follow him on Facebook or Twitter by clicking the buttons below or head over to his blog at http://www.DanDzombak.com